Is China Electronics Optics Valley Union Holding (HKG:798) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that China Electronics Optics Valley Union Holding Company Limited (HKG:798) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for China Electronics Optics Valley Union Holding

How Much Debt Does China Electronics Optics Valley Union Holding Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 China Electronics Optics Valley Union Holding had CN¥5.83b of debt, an increase on CN¥5.56b, over one year. However, because it has a cash reserve of CN¥1.89b, its net debt is less, at about CN¥3.94b.

How Healthy Is China Electronics Optics Valley Union Holding's Balance Sheet?

According to the last reported balance sheet, China Electronics Optics Valley Union Holding had liabilities of CN¥8.35b due within 12 months, and liabilities of CN¥2.31b due beyond 12 months. On the other hand, it had cash of CN¥1.89b and CN¥2.96b worth of receivables due within a year. So it has liabilities totalling CN¥5.81b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥2.66b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Electronics Optics Valley Union Holding would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Electronics Optics Valley Union Holding has a rather high debt to EBITDA ratio of 6.0 which suggests a meaningful debt load. However, its interest coverage of 3.3 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that China Electronics Optics Valley Union Holding saw its EBIT drop by 20% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Electronics Optics Valley Union Holding will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, China Electronics Optics Valley Union Holding burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, China Electronics Optics Valley Union Holding's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its EBIT growth rate fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that China Electronics Optics Valley Union Holding is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with China Electronics Optics Valley Union Holding (including 1 which is is concerning) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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